Cash Balance Plans for Larger Tax-Deferred Contributions
Cash Balance Plan: What is it? How does it work?
There are two main types of qualified retirement plans: defined contribution (DC) and defined benefit (DB). The maximum annual contribution to a DC plan is $54,000, while the contributions to a DB plan could be in excess of $215,000. This makes DB plans a much better option for those who are behind on retirement savings. Furthermore, by combining the two, you could have an annual contribution of over $269,000. Today we will discuss cash balance plans, a pre-tax DB plan with several characteristics similar to a more traditional 401(k) profit sharing plan.
A cash balance plan has the ability to supplement an existing 401(k) plan with substantially larger contributions and tax savings.
Under a defined contribution plan (e.g. profit sharing and 401(k) plan), the “contribution” is defined in the plan document and your balance at normal retirement is a function of contributions and investment returns. A defined benefit plan, on the other hand, does not define the contribution but rather defines the benefit that will be paid at retirement. In order to pay a monthly benefit, as defined under the terms of the defined benefit plan, you need to have a large enough sum accumulated by retirement to provide the required stream of income (benefit). The sum needed at retirement is considered a liability. The annual contribution needed to fund the liability is simply a time value of money calculation. For example, let’s assume you need $1,000,000 in 15 years to fund the “promised benefit,” you would need to contribute $46,342 each year for 15 years at a 5% interest rate to fully fund your obligation. At 3%, the annual contribution increases to $53,767. To some extent the only variable you can control is the interest rate assumption because the benefit is contractually promised in the plan document, and retirement in this example is 15 years away.
A cash balance plan is a type of defined benefit plan, but it has several characteristics that are similar to a profit sharing plan. The first is pay/contribution credits and the second is the hypothetical account balance. Unlike a profit sharing plan, the cash balance plan will also have a stated interest crediting rate defined in the plan document. Understanding these three components and how they work is critical to effectively managing a cash balance plan.
The cash balance plan document will state either a flat dollar amount or a percentage of a participant’s compensation that will be contributed (“allocated”) to their hypothetical account. This is typically referred to as pay credits or compensation credits.
Hypothetical Account Balance
The pay credits are allocated to the participant’s hypothetical account. It is hypothetical because the account does not really exist. Each year that the plan is active, the participant will receive a pay credit allocation plus an interest credit to their hypothetical account. At retirement, this hypothetical account balance will be converted to a benefit, hence the defined benefit. What is different about a cash balance plan is that the benefit is not explicitly defined but is determined from the accumulated hypothetical account. The only promise that is made is the amount of the pay credit that will be allocated to the participant’s hypothetical account each year. To illustrate the hypothetical account, let us assume the annual pay credit for a participant is $10,000 for 20 years and an interest crediting rate of 5%. At the end of 20 years, normal retirement in our example, the hypothetical account balance is $330,660. Annuitizing the hypothetical account balance would produce a benefit of approximately $21,510 annually. This annual benefit is the “defined benefit” of the plan and is the number that is used for non-discrimination testing and determining the meaningful benefit under IRC 401(a)(26).
Since this is a defined benefit plan, the document must state the rate of interest that will be credited to the participant’s hypothetical account each year. This interest crediting rate can be defined as a fixed rate, e.g. 5%, or a variable rate tied to some index. If a variable rate is used, the index is typically the 30 year Treasury Yield. Two key issues are in play when considering the fixed rate and the variable rate.
The first issue is the minimum participation regulations under IRC 401(a)(26). Compared to the 125-page definition of compensation, this vague section of the Code is only two paragraphs. The regulation states that the plan must benefit the lesser of 40% of the eligible workforce, or 50 participants. While this is the only official guidance, a letter written by the director of employee plans at the IRS went on to state that, in addition to this minimum participation rule, each participant should receive a “meaningful benefit.” Otherwise, the participants are not considered effectively participating. The IRS has unofficially taken the position that if a participant receives a 0.5% accrual then they are deemed to have received a meaningful benefit. For staff employees, the 0.5% accrual may be satisfied if the pay credit for example is 1.75% of their annual compensation. But how does this relate to the interest crediting rate of the plan?
The interest crediting rate is used to determine if the pay credit plus interest satisfies the 0.5% meaningful benefit accrual. A higher interest rate means you can get by with a lower contribution. Using the fixed rate method yields a very predictable contribution requirement for the staff. Conversely, under the variable rate method if interest rates fall then the staff contribution may have to be increased in order to satisfy the 0.5% meaningful benefit accrual. For example, let us assume that the variable interest crediting rate drops to 3.5% then the staff contribution may need to be increased from 1.75% of pay to 2.0% of pay. When considering IRC 401(a)(26), obviously the fixed rate method would be preferable.
The second issue is matching assets to liabilities. Under the fixed rate crediting method, if the actual investment returns are less than the fixed crediting rate then the hypothetical account balance, liability, will be in excess of the value of the plan’s assets. In other words, liabilities will be greater than assets, resulting in a deficit and underfunded plan. On the other hand, if the plan uses the variable rate method that is tied to an investable index then the interest credited to the hypothetical account balance will equal the plan’s assets. In this scenario assets will equal liabilities.
As you can see, there are pros and cons with each method. We lean toward using a variable rate because it is easier to match assets and liabilities, and through plan design we can manipulate eligibility and pay credits to more predictably satisfy the meaningful benefit requirement.
In addition to the interest crediting rate stated in the plan document, the document must also state the actuarial assumptions used to calculate the conversion of the hypothetical account balance to a benefit for testing purposes. Given the fact that most all participants take a lump sum distribution at retirement, we will only discuss the two interest rates and leave the “normal form of benefit” (life annuity, etc.) for another day.
The first interest rate is the pre-retirement rate. This rate is used to project forward the accumulation of the pay credits in order to determine the hypothetical account balance at retirement. If the plan is using the variable rate method for actual interest credits, it is ignored here and the pre-retirement rate is substituted. We cannot predict the future returns of a variable rate, so a fixed pre-retirement rate is stated in the plan document. This pre-retirement rate is used for all testing up until the point of retirement. Other methods are available, but they are beyond the scope of our discussion.
The post-retirement rate is typically a fixed rate and is used in the actuarial calculations at retirement to estimate the annual benefit if the hypothetical account balance is annuitized.
Cash Flow Impact
As with any defined benefit plan, the plan sponsor should consider the cash flow implications before finalizing the decision to implement a cash balance plan. After the first year of the plan, there is a minimum and maximum deductible amount. Sometimes the range between the minimum and maximum can be very large. However, we recommend that the aggregate pay credits of all participants be deposited to the trust annually, even if this is in excess of the required minimum. Contributing the pay credits annually will minimize funding issues down the road.
If the plan uses a fixed interest crediting rate method, then there will be years where the actual investment returns are less than the interest that is credited to participant accounts. If this situation persists, the liabilities of the plan (aggregate hypothetical account balances) will exceed the value of the plan’s assets resulting in an underfunded status, which could lead to mandated higher contributions and/or distribution restrictions.
Cash balance plans can be a very effective tool for increased pre-tax contributions. Conceptually, they are easier for plan sponsors and participants to understand (pay credits and interest credits) but they have quite a few moving parts. It is important to understand the interplay between the various components when establishing the plan, and for ongoing operation.
Contact us if you would like more information on cash balance plans.